Tarheel ConsultancyServices Bangalore, Karnataka
Course on Futures & Options For XIM -Bhubaneshwar
For PGP-II 2004-2006 Batch Term-IV: 2005
Part-I An Introduction
What is a Derivative Security? • Derivative securities, more appropriately termed as derivative contracts, are assets which confer the investors who take positions in them with certain rights or obligations.
Why Do We Call Them Derivatives? • They owe their existence to the presence of a market for an underlying asset or portfolio of assets, which may be considered as primary securities. • Consequently such contracts are derived from these underlying assets, and hence the name. • Thus if there were to be no market for the underlying assets, there would be no derivatives.
Broad Categories of Derivatives • Forward Contracts • Futures Contracts • Options Contracts • Swaps
More Complex Derivatives • Futures Options – Options contracts which are written on futures contracts • Compound options – Options contracts which are written on options contracts • Swaptions – Options on Swaps
Definition of a Forward Contract • A forward contract is an agreement between two parties that calls for the delivery of an asset on a specified future date at a price that is negotiated at the time of entering into the contract.
Forward Contracts (Cont…) • Every forward contract has a buyer and a seller. • The buyer has an obligation to pay cash and take delivery on the future date. • The seller has an obligation to take the cash and make delivery on the future date.
Definition of a Futures Contract • A futures contract too is a contract that calls for the delivery of an asset on a specified future date at a price that is fixed at the outset. • It too imposes an obligation on the buyer to take delivery and on the seller to make delivery. • Thus it is essentially similar to a forward contract.
Forward versus Futures • Yet there are key differences between the two types of contracts. • A forward contract is an Over-the-Counter or OTC contract. • This means that the terms of the agreement are negotiated individually between the buyer and the seller.
Forward vs. Futures (Cont…) • Futures contracts are however traded on organized futures exchanges, just the way common stocks are traded on stock exchanges. • The features of such contracts, like the date and place of delivery, and the quantity to be delivered per contract, are fixed by the exchange.
Forward vs. Futures (Cont…) • The only job of the potential buyer and seller while negotiating a contract, is to ensure that they agree on the price at which they wish to transact.
Options • An options contract gives the buyer the right to transact on or before a future date at a price that is fixed at the outset. • It imposes an obligation on the seller of the contract to transact as per the agreed upon terms, if the buyer of the contract were to exercise his right.
Rights • What is the difference between a Right and an Obligation. • An Obligation is a binding commitment to perform. • A Right however, gives the freedom to perform if desired. • It need be exercised only if the holder wishes to do so.
Rights (Cont…) • In a transaction to trade an asset at a future date, both parties cannot be given rights. • For, if it is in the interest of one party to go through with the transaction when the time comes, it obviously will not be in the interest of the other.
Rights (Cont…) • Consequently while obligations can be imposed on both the parties to the contract, like in the case of a forward or a futures contract, a right can be given to only one of the two parties. • Hence, while a buyer of an option acquires a right, the seller has an obligation to perform imposed on him.
Options (Cont…) • We have said that an option holder acquires a right to transact. • There are two possible transactions from an investor’s standpoint – purchases and sales. • Consequently there are two types of options – Calls and Puts.
Options (Cont…) • A Call Option gives the holder the right to acquire the asset. • A Put Option gives the holder the right to sell the asset. • If a call holder were to exercise his right, the seller of the call would have to make delivery of the asset.
Options (Cont…) • If the holder of a put were to exercise his right, the seller of the put would have to accept delivery. • We have said that an option holder has the right to transact on or before a certain specified date. • Certain options permit the holder to exercise his right only on a future date.
Options (Cont…) • These are known as European Options. • Other types of options permit the holder to exercise his right at any point in time on or before a specified future date. • These are known as American Options.
Longs & Shorts • The buyer of a forward, futures, or options contract is known as the Long. • He is said to have taken a Long Position. • The seller of a forward, futures, or options contract, is known as the Short. • He is said to have taken a Short Position. • In the case of options, a Short is also known as the option Writer.
Swaps • A swap is a contractual agreement between two parties to exchange specified cash flows at pre-defined points in time. • There are two broad categories of swaps – Interest Rate Swaps and Currency Swaps.
Interest Rate Swaps • In the case of these contracts, the cash flows being exchanged, represent interest payments on a specified principal, which are computed using two different parameters. • For instance one interest payment may be computed using a fixed rate of interest, while the other may be based on a variable rate such as LIBOR.
Interest Rate Swaps (Cont…) • There are also swaps where both the interest payments are computed using two different variable rates – For instance one may be based on the LIBOR and the other on the Prime Rate of a country. • Obviously a fixed-fixed swap will not make sense.
Interest Rate Swaps (Cont…) • Since both the interest payments are denominated in the same currency, the actual principal is not exchanged. • Consequently the principal is known as a notional principal. • Also, once the interest due from one party to the other is calculated, only the difference or the net amount is exchanged.
Currency Swaps • These are also known as cross-currency swaps. • In this case the two parties first exchange principal amounts denominated in two different currencies. • Each party will then compute interest on the amount received by it as per a pre-defined yardstick, and exchange it periodically.
Currency Swaps (Cont…) • At the termination of the swap the principal amounts will be swapped back. • In this case, since the payments being exchanged are denominated in two different currencies, we can have fixed-floating, floating-floating, as well as fixed-fixed swaps.
Actors in the Market • There are three broad categories of market participants: • Hedgers • Speculators • Arbitrageurs
Hedgers • These are people who have already acquired a position in the spot market prior to entering the derivatives market. • They may have bought the asset underlying the derivatives contract, in which case they are said to be Long in the spot.
Hedgers (Cont…) • Or else they may have sold the underlying asset in the spot market without owning it, in which case they are said to have a Short position in the spot market. • In either case they are exposed to Price Risk.
Hedgers (Cont…) • Price risk is the risk that the price of the asset may move in an unfavourable direction from their standpoint. • What is adverse depends on whether they are long or short in the spot market. • For a long, falling prices represent a negative movement.
Hedgers (Cont…) • For a short, rising prices represent an undesirable movement. • Both longs and shorts can use derivatives to minimize, and under certain conditions, even eliminate Price Risk. • This is the purpose of hedging.
Speculators • Unlike hedgers who seek to mitigate their exposure to risk, speculators consciously take on risk. • They are not however gamblers, in the sense that they do not play the market for the sheer thrill of it.
Speculators (Cont…) • They are calculated risk takers, who will take a risky position, only if they perceive that the expected return is commensurate with the risk. • A speculator may either be betting that the market will rise, or he could be betting that the market will fall.
Hedgers & Speculators • The two categories of investors complement each other. • The market needs both types of players to function efficiently. • Often if a hedger takes a long position, the corresponding short position will be taken by a speculator and vice versa.
Arbitrageurs • These are traders looking to make costless and risk-less profits. • Since derivatives by definition are based on markets for an underlying asset, it is but obvious that the price of a derivatives contract must be related to the price of the asset in the spot market.
Arbitrageurs (Cont…) • Arbitrageurs scan the market constantly for discrepancies from the required pricing relationships. • If they see an opportunity for exploiting a misaligned price without taking a risk, and after accounting for the opportunity cost of funds that are required to be deployed, they will seize it and exploit it to the hilt.
Arbitrageurs (Cont…) • Arbitrage activities therefore keep the market efficient. • That is, such activities ensure that prices closely conform to their values as predicted by economic theory. • Market participants, like brokerage houses and investment banks have an advantage when it comes to arbitrage vis a vis individuals.
Arbitrageurs (Cont…) • Firstly, they do not typically pay commissions for they can arrange their own trades. • Secondly, they have ready access to large amounts of capital at a competitive cost.
Assets Underlying Futures Contracts • Till about two decades ago most of the action was in futures contracts on commodities. • But nowadays most of the action is in financial futures. • Among commodities, we have contracts on agricultural commodities, livestock and meat, food and fibre, metals, lumber, and petroleum products.
Food grains & Oil seeds • Corn • Oats • Soybeans • Wheat
Livestock & Meat • Hogs • Feeder Cattle • Live Cattle • Pork Bellies
Food & Fibre • Cocoa • Coffee • Cotton • Sugar • Rice • Frozen Orange Juice Concentrate
Metals • Copper • Silver • Gold • Platinum • Palladium
Petroleum & Energy Products • Crude Oil • Heating Oil • Gasoline • Propane • Electricity
Financial Futures • Traditionally we have had three categories of financial futures: • Foreign currency futures • Stock index futures • Interest rate futures • The latest entrant is futures contracts on individual stocks – called single stock futures or individual stock futures